Question

If the reserve requirement were eliminated (and the currency ration is 40% and the excess reserve ratio is 1%), how much would this change size of the money supply? (3 Points)

What is the practical justification of the reserve requirement, besides as a monetary policy tool?

Answer 1

Money multiplier in this case becomes a greater value at (1 + C-D)/(C-D + ER-D) = (1 + 40%)/(40% + 1%) = 3.4146

Reserve requirements are made mandatory by law so that banks do not lend all the reserves and face a critical situation as that of a run on bank when several depositors demand withdrawl simultaneously. Banks are therefore required to maintain a given level of liquidity in this form so that they can let few depositors take their money as and when they need.